Investing in a tax-advantaged retirement account can provide you with a way to build a nest egg over time—and live comfortably after you stop working. When you invest in a 401(k) or Traditional IRA, you get a lower tax bill today, but that benefit comes with terms and conditions down the road. When you reach age 72, Uncle Sam requires you to take minimum withdrawals, called required minimum distributions (RMDs), or face a hefty penalty. Here’s a look at how to lower your required minimum distributions.
What Is an RMD?
Your required minimum distribution, or RMD, is the required amount you must withdraw from certain accounts each year. The RMD kicks in the year after you reach age 72 and applies to the following accounts:
- 401(k), including Roth accounts
- Traditional IRA
- SEP IRA
- SIMPLE IRA
- 403(b)
- 457(b)
- Profit-sharing plans
A formula considering your account balances and life expectancy determines how much you must withdraw each year. If you don’t meet your RMD, you face a penalty of 50% of the amount you should have taken.
Reducing your RMD can help you keep your tax bill manageable as you get older. You can speak with a personal finance professional or retirement specialist to help you determine which strategies are likely to work best for you. Here are five possible ways to do it.
1. Manage Your Account Withdrawals
The smaller your account balances when you reach age 72, the lower your RMD will be. You can start withdrawing money from most of your tax-advantaged accounts without penalty at age 59 ½. Withdrawals from non-Roth accounts are still taxed at your ordinary rate, but it can help shrink your overall balances. This strategy might work well if you’re in a lower tax bracket during retirement.
2. Take Advantage of a Roth IRA Conversion
One of the advantages of a Roth IRA is the fact that your account balances aren’t subject to RMDs. You can withdraw contributions at any time without penalty. Plus, after you have had your Roth IRA for five years and you’re older than 59 ½, you can withdraw the earnings tax-free as well.
A Roth conversion allows you to roll money from other accounts into a Roth IRA. You can do this with your 401(k) and with other IRA accounts. However, it’s important to note that you will pay taxes on the converted funds at your ordinary income tax rate. Performing a Roth conversion on all your money at once could trigger a massive tax bill.
Instead, consider converting a portion of your non-Roth accounts at various intervals. After you stop working and are in a lower tax bracket, it might make sense to convert some of your funds, bringing you to the top of your tax bracket but not pushing you higher. You can convert more of your account balances in a later year. Over time, the balances subject to RMDs will diminish while you grow your Roth IRA as a source of non-taxable income later in retirement.
If you have Roth 401(k) funds, converting those into a Roth IRA has fewer tax consequences and you can move your money from an account with RMDs directly to one that doesn’t have them.
3. Take Social Security Benefits Later
Rather than taking Social Security when you reach age 62, consider putting off claiming your benefits until later.
If you can put off taking Social Security benefits, you can draw down your account balances in a way that allows you to manage your long-term tax bill. Later, if you wait until age 72 to begin taking Social Security, your monthly benefit will be larger, and the balances subject to RMDs will be lower.
4. Work Longer
If you’re working, you aren’t required to take required minimum distributions from your employer’s 401(k)—even if you’re 72.
However, if you have a Traditional IRA, other non-Roth IRA, or an old 401(k) account from a former employer, you still need to take RMDs from those accounts. To put off taking RMDs from other accounts, find out if you can roll those old retirement plans into your current 401(k).
Realize, though, that once you quit working, you’ll be subject to RMDs. Weigh the tax consequences and speak with a professional to see if this makes sense for you. Once you stop working, you’re likely to be in a lower tax bracket, which could help you save money.
5. Make a Qualified Charitable Donation
Finally, you can reduce your RMD when you donate from your retirement account to a qualified charity. With a qualified charitable donation (QCD), you can take up to $100,000 from your IRAs and donate it to charity tax-free. On top of that, your charitable donation counts toward your RMD.
Charitable donations can be a good strategy if you have enough money to meet your living expenses, and your RMD does little beyond increasing your tax bill. Plus, you get that warm feeling from helping a good cause.
Bottom Line
Any strategies, or some used in combination, might help you reduce your required minimum distributions and manage your tax bill during retirement. Carefully consider what might work best for you and consult a knowledgeable financial professional to determine a course of action to benefit your finances.
This article is intended for general informational and educational purposes only, and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.
